No single factor has characterized this 10-year bull market more than momentum. It’s a relatively new and controversial factor, and some experts like Research Affiliates founder Rob Arnott still question its viability. Dimensional Fund Advisors, the granddaddy of factor investing, doesn’t offer a momentum fund, though DFA disciples say the firm incorporates the factor into its trading strategies.
But momentum stocks aren’t hard to identify. Essentially, if one took the highest-octane components out of either Morningstar’s growth stock universe or the Nasdaq 100, one could create an ETF with Big Mo. And many have.
A landscape dominated by disruptive technology giants growing earnings at rates of 20% or more provided the investing theme of the decade. When set against a backdrop of near-zero interest rates, those earnings are perceived as even more valuable.
There is only one problem for investors who want to isolate this kind of unbridled euphoria. Momentum has an uncanny habit of turning on a dime. That’s why many funds and ETFs following this factor rebalance monthly. As a result, the factor’s turnover, trading costs and tax consequences can rival those of hedge fund strategies. Most other factor strategies rebalance quarterly or semiannually. Matt Bartolini, head of Americas research at State Street’s SPDRs unit, argues the costs associated with momentum “can decay” much of the premium associated with the group.
Despite its obvious attraction in the 10-year rearview mirror, momentum also leaves portfolios exposed to tail risk and sudden sentiment shifts. That became evident in last year’s fourth quarter. “Momentum works really well in a continuous up market,” says Duy Nguyen, chief investment officer and senior portfolio manager at Invesco Investment Solutions. “It does not tell you when the inflection point is coming.”
According to Bartolini, the performance of both quality and value factors correlate more closely with different stages of the economic cycle than momentum. Specifically, he says, value tends to work well early in the cycle while quality often does best late in an expansion.
Critics argue that momentum is really just a form of performance-chasing that can get you into hot stocks late in the cycle. In early November, Jim Cramer, co-founder of TheStreet.com, raged in public that the liquidation in momentum ETFs was vaporizing the value of his Visa and Mastercard holdings. Other stocks favored by momentum funds, most notably the FANG stocks, also got slammed, but many of the latter group had specific problems of their own (such as regulatory issues).
Observers thought that blaming ETFs for the rapid depreciation of this factor was simplistic. In a risk-on, risk-off world, more hedge fund managers probably jump in and out of white-hot stocks faster than momentum ETFs do.
Among the sophisticated institutional investors Hunstad deals with at Northern Trust, there is a growing cross section of investors and managers preparing their portfolios for a downturn, and they also believe that portfolios overexposed to momentum stocks are highly vulnerable. “Correlations among sectors are declining, and there is more individual stock dispersion,” Hunstad says. Yet giant firms like BlackRock and Northern Trust are still not calling for a recession.
Few believe that U.S. equities are near 1999 levels, though there are some similarities. Fully 95% of the price of Amazon, probably the leading momentum stock, is “based on future earnings,” Hunstad maintains. “They are going to have to grow to 10% of GDP over the next 10 years to justify that.”